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December 10, 2012

Warning on VAs to Advisors: Be Afraid. Be Very Afraid.

Reducing the tax incentives to participate in 401(k) plans – one idea the president and some on Capitol Hill are considering to avert the fiscal cliff – has led some observers to speculate that variable annuities will become more important in 2013 as the best remaining tax-deferred savings vehicle.

But insurance expert Glenn Daily (left), a variable annuity skeptic, remains firm in his opposition. Asked, in an interview with AdvisorOne:, whether the fiscal cliff would increase demand for the much maligned product, the New York-based fee-only advisor refused to speculate, saying, “I don’t know. We’ll have to wait and see.”

While there are some cases in which Daily says variable annuities are advisable, the independent insurance consultant’s main advice about VAs continues to be: Stay away!

AdvisorOne: In your books, articles and other public comments, you have long eschewed variable annuities. Do you have anything positive to say about them?

Daily: Variable annuities are problematic for me. The one use I do have for them is using them for a tax-free exchange for life insurance policies that have an excessive tax basis, where the tax basis is higher than the cash surrender value. If you do a 1035 exchange, you can preserve the tax basis and you can use the annuity as a tax shelter. Let the money grow, then cash it out, and you won’t pay income tax on the gain up to the tax basis.

So that’s a no-brainer for me. If you don’t consider that as an advisor, you’re committing malpractice. I don’t see the benefit of not taking advantage of that.

AdvisorOne: Could you give an illustration of how that would work?

Daily: You have a life insurance policy where you put in $100,000 in premiums and the cash value is $60,000 and you decide–for whatever reason–you don’t need the life insurance policy. Instead of walking away from it, you can do an exchange to an annuity. Let the $60,000 grow until it becomes $100,000 and you won’t pay income tax on the $40,000 difference. The annuity can be deferred or immediate, fixed or variable–it doesn’t matter.

AdvisorOne: Could you offer reasons a client would want to retire his life insurance policy?

Daily: If you can’t pay the premiums any more, or your income drops, or the policy is not performing well or someone inheriting money and hence not needing it anymore.

AdvisorOne: Is there no other justification, beyond a 1035 exchange, for variable annuities?

Daily: There’s tax deferral: You’ve maxed out on your 401(k). So you find a VA with low expenses and no surrender charge. A lot depends on tax rates now and in the future. That’s a justifiable use of a deferred annuity.

AdvisorOne: That’s what a lot of advisors want them for, and presumably will want them for, if 401(k) contributions are capped. You don’t sound so hostile to VAs after all.

Daily: When you start getting into the guarantees, that’s when it becomes more difficult. Do investors know how to take advantage of the guarantee? These are options they are holding. Do people understand when they should take withdrawals? Do they understand whether it makes sense to replace what they own in the future? It’s not a simple decision. It’s an option. How do you figure out what the option is worth?

AdvisorOne: How do you figure out what the option is worth? Who has that expertise?

Daily: You have to talk to a financial economist like Moshe Milevsky. That group [of experts] does not include me nor the vast majority of financial advisors.

It’s an expensive proposition to get an economic value of the guarantee. You have to model the contract terms. You may have a roll up. There may be an incentive to not take withdrawals at the beginning. There may be different investment choices–they may be restricted or not restricted.

You’re getting involved in a complicated product. I suspect most people don’t know what they’re getting.

AdvisorOne: What if a client asks you evaluate annuity benefits?

Daily: I send people academic papers filled with stochastic differential equations so people can understand what they’re getting into. Basically, I’m saying people are not being serious about it.

Valuing the benefits is expensive. It’s hard to find people who can do it. I don’t know if Moshe Milevsky is offering this service for advisors.

I decline to accept assignments where people ask me to opine on which variable annuity offers the best guarantee. How can I answer that question knowing what I know? My AXA Equitable blog post discusses all this.

AdvisorOne: So how should advisors approach retirement income investing for clients?

Daily: I like immediate annuities. I like deferred income annuities. These are two insurance products that academics and economists seem to believe are undersold.

AdvisorOne: But do today’s low interest rates lessen the attractiveness of these two options?

Daily: That’s an argument for doing a ladder and buying some over time. Or just wait–if you can–till rates go up. You give up the income in the interim.

AdvisorOne: What variable annuities are you buying for your 1035 exchanges?

AdvisorOne: What do you suggest advisors do if, despite the cautions you are offering, clients are demanding variable annuities?

Daily: People ought to read the prospectus. You should read it and make sure you understand it. Give people a quiz: ‘Read pages 20-26 and explain it to me. And if you can explain it to me, I’ll sell it to you.’